June ECB meeting preview: The long-awaited cut

Investors and financial markets will be very surprised – and not at all happy – should Thursday’s ECB announcement not include the first cut in key interest rates since September 2019. With even the more hawkish Governing Council (GC) members having now adopted a notably more dovish line, recent central bank rhetoric has seemingly made a 25 basis point reduction a done-deal. This would lower the key deposit rate from its current record high to 3.75 percent, the refi rate to 4.25 percent and the rate on the marginal lending facility to 4.50 percent.

Assuming that rates are cut, the focus will be on any forward guidance for possible clues about when the next ease might be delivered. Any move on Thursday would necessitate some amendment to the existing language that, in a nutshell, says that current levels are thought to be appropriate for sustainably meeting the inflation target. A cut this week would probably receive unanimous GC support but beyond that, the outlook for policy is much less clear. The bank will almost certainly reiterate it remains data-dependent but as early as April, the head of the Lithuanian central bank Gediminas Simkus was already suggesting that there could be as many as four cuts between now and year-end. His Portuguese counterpart, Mario Centeno, has also pointed out that even lowering rates by 100 basis points would still leave policy restrictive. However, other members will be much more cautious and, on balance, any new forward guidance is likely to be non-committal.

Meantime, while interest rates are falling, QT will still be tightening financial conditions by shrinking the bank’s balance sheet. From next month, QT will be expanded by including the pandemic emergency purchase programme (PEPP) with an average monthly target for disposals of €7.5 billion through December. Moreover, from 2025, partial reinvestment will be discontinued, meaning that the rate of decline will accelerate again. This raises the risk of putting fresh downside pressure on money supply growth just at the time when it is showing signs of recovery.

For a while now, financial markets have fully priced in a 25 basis point cut this month. However, expected rate reductions over the rest of the year and through 2025 have been tempered further since the April meeting. At 3.4 percent, 3-month money rates at year-end are now priced about 30 basis points higher than expected just before the last announcement and imply only two cuts this year. The December 2025 call has also been raised by nearly 40 basis points to 2.9 percent.

The less aggressive easing profile reflects the latest inflation developments. Hence, the decline in the headline rate stalled in May with the flash data showing a 0.2 percentage point rise to 2.6 percent, its first increase in 2024 and matching the highest level since last December. More significantly, the core measures also accelerated with the narrow gauge climbing from 2.7 percent to 2.9 percent, its first advance since June 2023. In addition, and perhaps most worryingly, inflation in services jumped fully 0.4 percentage points to 4.1 percent, a 7-month high. This will not sit all at well with the GC hawks and provides a strong argument for not following a June ease with another as soon as July.

This view is backed up by the latest wage data which have painted a decidedly mixed picture. The ECB’s own negotiated wage series showed a slight acceleration from an annual 4.5 percent rate at the end of 2023 to 4.7 percent last quarter. However, data covering the period when most agreements take place pointed to some underlying moderation, a scenario broadly consistent with the monthly wage tracker compiled by Indeed. Even so, the bottom line is that wages are still rising rapidly – notably in Germany for which the latest Bundesbank estimate was fully 6.2 percent. The ECB still expects wages to cool during 2024 but with the labour market so tight – the April jobless rate even hit a new record low – the latest developments provide reason for delivering a cautious approach to easing.

Inflation expectations in April were equally mixed with the ECB’s latest survey finding households’ view 1-year ahead either flat or marginally higher but over the 3-year horizon, slightly weaker. Still, in total the report suggested no significant change versus March and should not pose a threat to an interest rate reduction this week. That said, with all the measures still well above 2 percent, the results also provided further reason for not rushing into the next cut.

As it is, economic data released since the April meeting have, on balance, been on the strong side of market expectations. Over the period, Econoday’s relative performance index (RPI) averaged 5 and, after omitting inflation indicators (RPI-P), 13. Accordingly, both measures show activity surprising on the upside, a development that may see a slight upward revision to the bank’s near-term growth projection. However, any change to the key inflation forecast is unlikely to impact this week’s interest rate decision.

In summary, forecasters and financial markets are very confident that the ECB will announce a 25 basis point cut in key interest rates on Thursday. Beyond that, another ease as soon as July, the last meeting before the summer recess, might well be too aggressive for most GC members. Inevitably, much will depend upon the interim inflation updates and the ECB’s own forecasts so September may be a more likely month. Either way, Chief Economist Lane said recently that policy must remain restrictive throughout 2024. The central bank will also be keeping a close eye on the exchange rate. The ECB is always quick to point out that it has no target for the euro but it is also fully aware that easing before the Federal Reserve could unsettle the currency and provide prices with an unwanted boost. Decoupling could be a risky business.